No Penalty For Erroneous Claim Based On Bona Fide Interpretation Of Tax Treaty: Madras High Court

The Madras High Court on 5 February held that an erroneous claim of double taxation relief by itself cannot lead to a penalty under Section 271(1)(c) of the Income Tax Act, 1961 when the taxpayer has fully disclosed the relevant income and the claim arises from a bona fide interpretation of law.

A Division Bench of Dr. Justice Anita Sumanth and Justice Mummineini Sudheer Kumar heard appeals filed by the Commissioner of Income Tax against Indian Overseas Bank challenging an order of the Income Tax Appellate Tribunal (Tribunal), which had deleted the penalty imposed on the bank for the assessment years 2006–07 and 2007–08.

The Court stated:

“...the levy of penalty under Section 271(1)(c) is thus not automatic, and has to be evaluated on the facts and circumstances of every case. It has also to be seen as to what the basis of the levy is. In this case, the levy of penalty is based on a disallowance of a claim which is a question of law. Though erroneous, the error is bonafide and is based on a plausible understanding of the law at the relevant point of time."

The dispute arose after Indian Overseas Bank claimed double taxation relief on income earned by its Hong Kong branch by invoking the Double Taxation Avoidance Agreement (DTAA) between India and China.

During the assessment proceedings, the Assessing Officer (AO) disallowed the claim for treaty relief after holding that Hong Kong, a Special Administrative Region, was not covered under the treaty with China at the relevant time.

The Commissioner of Income Tax (Appeals) confirmed the disallowance. The bank did not pursue the quantum dispute further.

Following the disallowance, the AO imposed a penalty under Section 271(1)(c) of the Income Tax Act on the ground that the bank had made an incorrect claim of treaty benefit.

On appeal, the Tribunal set aside the penalty, holding that the issue involved a question of legal interpretation and did not amount to concealment of income. The Commissioner of Income Tax then approached the High Court.

The Division Bench observed that the bank had fully disclosed the income earned by its Hong Kong branch in the return of income. The disallowance arose only because the treaty between India and China did not extend to Hong Kong at the relevant time.

The Court noted that the bank formed its understanding on the fact that Hong Kong became part of China in 1997. The Bench also noted that the legislative clarification enabling tax treaties with specified territories came only later.

The Bench stated:

“the liability to penalty under Section 271(1)(c) applies in situations where the officer concerned is satisfied that any person has concealed the particulars of income or furnished inaccurate particulars of income. In the present case, it has never been the Department's case, as seen from the record that the assessee had either concealed or furnished inaccurate particulars of the income earned by the Hong Kong branch.”

The Court further observed that the disallowance arose from an erroneous legal interpretation and not from concealment or misreporting of income. The taxpayer had transparently disclosed the relevant income and the claim in its return, and therefore the essential conditions for imposing a penalty were not satisfied.

The Bench also clarified that the mere rejection of a claim or addition in assessment does not automatically justify the imposition of a penalty. It held:

“the disallowance effected in the quantum assessment is fully based on the return of income filed by the assessee and the claim made thereunder. The only reason for which the disallowance had been made, was that it was not supported by the DTAA with China. This error, a pure error of law and interpretation, would not attract the penal provisions of Section 271(1)(c).”

Accordingly, the Court dismissed the appeals filed by the Revenue and confirmed the Tribunal's decision to delete the penalty imposed on the bank.

For Petitioner: Senior Standing Counsel, V. Pushpa

For Respondent: Advocate, A.S. Sriraman for S. Sridhar